How would the carbon market affect the choice of input factors for production? A duopolistic model

Abstract

Carbon emissions trading scheme has been implemented in various countries to induce low-carbon production activities of firms. In this circumstance, firms can environmentally adjust the ratio of inputs to produce the final goods. This paper investigates the optimal choice of input factors for production where there exists a carbon market. We focus on a duopolistic market competition where two firms compete with homogeneous final goods, which are produced using two conceptual inputs: the pollutive input and the eco-friendly input. We derive the optimal amount of input by using the concept of Nash equilibrium and show that the optimal input ratio is not affected by the decision of the competing firm and tends to be biased towards cheaper inputs including the carbon price. Numerical analysis using the Korean thermal power generation industry shows that the carbon market leads firms to reduce the pollutive input rather than increase the eco-friendly input. Also, sensitivity analysis on the carbon price shows that the increase of the carbon price reduces production quantity, which results in the decrease of the firm's profits and total emissions. Social welfare is likely to experience positive effects only when considering the intangible benefits of the reduction in carbon emissions.